Sequestration: Should We Be Worried?

February 27, 2013

Last week it was speculation that the Fed could tap the brakes on its easy money policy. This week, the looming mandatory budget cuts are dominating the news. Just as we saw with the Fiscal Cliff, the rhetoric is flying and there are plenty of unanswered questions for us to chew on. Just today, Ben Bernanke testified that the sequestration would weigh on the economic recovery and make it more challenging to reduce the deficit.

My inbox has been full to the brim with questions about what to expect this Friday, so let's take some time to get up to speed on sequestration.

What is sequestration?

Back in 2011, Congress passed a deficit reduction law that scheduled $85 billion in across-the-board spending cuts in case the super committee couldn't reach an alternative budget plan. As we all know, Congress has failed to reach a compromise, so these mandatory cuts are scheduled to start on Friday, March 1 and would be implemented over seven months.

These cuts won't impact Medicare, Medicaid or Social Security, but they translate into about a 9% reduction for non-defense programs like the EPA, the FAA and U.S. Customs and Border Protection. Meanwhile the Department of Defense would sustain a 13% cutback for its programs.

Is it going to be as bad as the White House predicts?

Currently, the White House predicts dire consequences for the U.S. economy, most notably that 800,000 defense employees would be forced to take unpaid leave. Much of the media has latched on to this and is forecasting doomsday scenarios of three-hour lines at the airport, outbreaks of food-borne bacteria and threats to national security.

The way I see it, these are all mostly scare tactics. It's true that President Obama will have some tough decisions to make. It will be interesting to see how he prioritizes the cuts, but ultimately even with the cuts, total spending will still increase in 2013. After all, the $85 billion in spending cuts amounts to just 2.4% of the federal budget. In the end, the House of Representatives controls federal spending and through the sequestration they are forcing President Obama to rein it in.

How will this affect Wall Street?

That being said, I think the stock market could actually rally when these mandatory cuts commence. I expect that Wall Street would celebrate that the federal government is trying to live within its own means instead of growing faster than tax revenues. I also expect that the news media will continue to conjure drastic imagery of aircraft carriers that cannot be refueled, fewer school lunches and other scare tactics.

Ultimately, we'll have to wait to see what happens on Friday, but I think it's far too soon to panic over the scheduled cuts.